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fixed income and the end of monetary easing

May 2018

Why investors shouldn't fear higher bond yields

US 10-year Treasury yields have breached 3 per cent heralding tougher times for bond investors. Flexibility and a longer time horizon can boost returns.

Bond bears are out in force. Now that yields on benchmark 10-year US Treasuries have breached the 3 per cent level for the first time since 2014, they’re arguing a fully-fledged market correction could be round the corner.

Fixed income investors are understandably unsettled by the prospect of higher interest rates – not least because yields have trended down for most of the past 35 years.

But that doesn’t mean bonds should be jettisoned. Although the era of easy money looks to be coming to an end, fixed income securities will continue to provide income and stability to a diversified portfolio.

To understand why, it’s important to appreciate that what counts is not whether you are invested in bonds, but how you are invested in them.

One important observation is that bond fund maths will always serve fixed income investors well over the long run. 

benefit of time
Initial bond yield compared with annualised real return over 5-year horizon
10 year Treasury yield

Source: Pictet Asset Management, Thomson Reuters Datastream. Data covering period 30.12.1988 - 30.04.2018.

Even if higher rates may mean incurring capital losses on existing bond holdings, they also mean higher yields on new bonds.

Bond fund mechanics dictate that, when rates are rising, money received from any maturing bonds can be reinvested into new paper with higher yields. Over time this can pay off: historical analysis from our strategy team shows a positive correlation between the initial yield and real returns when investing over a five-year period (see chart).

Furthermore, in the three decades to 1981, while benchmark Treasury yields increased more than five-fold to well above 15 per cent – which is to say bond prices were falling– average annual government bonds returns remained positive.There is every reason to believe that performance will hold up this time too, especially as the rise in yields is expected to be far more modest.

Looking far and wide

The bond investor’s second ally is diversification.

History shows that portfolios which are not restricted to set regions, or tied to benchmarks or asset types, have a much better chance of successfully navigating difficult markets.

Spreading investments across the broadest possible range of fixed income assets and currencies, while keeping a tight rein on risk, can improve performance.

For example, in the Pictet-Absolute Return Fixed Income Fund, we believe the global economic backdrop is still positive for riskier asset classes. Although growth appears to have peaked at the end of 2017, it is still running at very strong levels and inflation remains relatively tame.

Such an environment is one that favours certain parts of the bond market, including emerging market dollar denominated bonds. This is a long-held strategy in our portfolio, which also ties in with the structural theme of China's economic transition towards domestic consumption. On a three to five year horizon, we believe that will translate into a lower potential growth rate, less demand for commodities and exchange rate liberalisation.

The risk here is that growth slows too much, but the Chinese authorities appear to be on the case. Last month's surprise cut in reserve requirement ratios (RRR) offers further proof that Beijing is happy to deliver stimulus when needed.

the curve of opportunity

Yield spread between 5 year and 30 year US Treasuries, basis points

Yield spread, 5 to 30 year Treasury bonds

Source: Pictet Asset Management, Thomson Reuters Datastream. Data covering period 04.01.2000  – 01.05.2018.

In the developed world, though, major central banks are in tightening mode. That offers opportunities for yield curve strategies, which are designed to profit from changes in yields and interest rate expectations and can be targeted by time horizon.

Take the US. The balance of probabilities is that its economy’s resilience will keep the Federal Reserve on a tightening path – for now. As long as the labour market looks strong, three more interest rate hikes in 2018 still look likely.

Turning the Fed from its policy course is like turning a tanker – it takes time and consensus. But over the medium term, it's entirely possible that US monetary policy tightening ends earlier than markets currently expect, and that's something for investors to keep in mind. If US interest rates peak, say, at the end of this year rather than in 2019, shorter-dated bonds could gain in value at the expense of longer-maturity ones, steepening the yield curve (see chart). That's a possibility we can position for using interest rate swaps.

So, while 3 per cent Treasury yields may have hit a psychological pain barrier for some investors, we believe that with the right approach, fixed income markets continue to offer opportunities for attractive risk-adjusted returns over the long run – as long as you know which markets to explore and have the flexibility to do so.